For index funds, exchange-traded funds (ETFs) and similar products, winning out over competitors is often a result of minute differences in return levels. Fees are low, and many funds track highly similar benchmarks. Some ETFs offer expense ratios as low as 0.03%. At the same time, however, ETFs can also produce revenue by lending out securities, bringing in added returns for shareholders and including hidden fees for managers of those funds. While many investors are not aware of this practice, it remains a significant business and revenue source; according to a recent report by Barron's, on any given day, it's likely that more than $2.3 trillion worth of securities will be loaned out.

ETF Securities Lending Practices

ETFs and mutual funds may lend out up to 50% of their unlevered securities portfolios at any given time, according to pertinent securities laws. These funds offer these loans to borrowers who then pay interest. In most cases, these borrowers are short sellers who are making a bet against those securities. In return, the ETF shareholders and money managers earn additional returns as a result of the interest those borrowers pay.

BlackRock, Inc. (BLK) managing director for securities lending Jason Strofs indicates that this is a significant business: "about $3 trillion of our assets we consider lendable, which consists of iShares ETFs, mutual funds, collective trusts, and separate accounts," he says. "Across that $3 trillion, roughly 9% of those securities are out on loan on any given day."

Securities Lending Can Differentiate Funds

While securities lending may seem like a straightforward way for ETF shareholders and managers to increase their returns, it's important to keep in mind that there are also risks associated with this practice. In comparing two ETFs that track the same benchmark, Barron's illustrated these risks. Take, for instance, the $1.3 billion Vanguard Russell 2000 (VTWO) and compare it against the $41 billion iShares Russell 2000 (IWM). Vanguard's expense ratio is lower than that of iShares (0.15% compared with 0.2%). However, in the past five years, iShares has managed to deliver an annualized return of 11.90% as compared with Vanguard's 11.89%. The benchmark Russell 2000 has underperformed both of these ETFs over the same period, generating only 11.84% returns.

Why the difference in performance between VTWO and IWM? It's likely due in large part to securities lending. According to the 2017 annual report, the iShares ETF maintained about $4.8 billion in securities on loan, compared with average assets of $31.7 billion for the same fiscal-year period. These loans generated $68 million in interest, or 0.21% of the ETF's total assets. This was enough to cover the expense ratio and then some. That is likely a crucial factor in how iShares beat the Russell benchmark for that period.

By comparison, the Vanguard fund loaned significantly less during that period. It loaned only $25.1 million as compared with $1.4 billion in average assets. This generated $1.9 million in interest, for an interest rate of 0.14%. Despite having a lower expense ratio than the iShares fund, Vanguard was thus not able to outperform its competitor.

Complications and Risks

In the case above, it may seem that significant securities lending is helpful when it comes to one ETF finding an advantage over its competition. However, because iShares lent out 15% of its assets compared with Vanguard's 2%, the former fund took a much higher level of risk. If borrowers default, for instance, that could cause problems; this is even despite the regulatory measures in place to insure that ETF loans are protected. Lending can also create conflicts of interest, particularly if an ETF invests lending collateral in affiliated money-market funds, thereby incentivizing overlending practices in order to collect additional fees. Many shareholders are unaware of these lending trends, although they can increase risk.